I decided to become an economist at age 16, but I also started reading my grandmother’s used copies of Forbes. After getting a Ph.D. from Duke and working for three years as a professor, I found my calling in the business world. I began as a corporate economist (PG&E, Nerco, First Interstate Bank) before entering consulting, helping business leaders connect the dots between the economy and business decisions. I wrote Businomics: From the Headlines to Your Bottom Line—How to Profit in Any Economic Cycle to help corporate executives and small business owners understand how the economy impacts their companies. I’m the longest-tenured member of the Oregon Governor’s Council of Economic Advisors, chairman of the board of Cascade Policy Institute and senior fellow at the National Center for Policy Analysis. My friends and fans love their monthly fix of economic charts, a 60-second scan of the economy. The latest edition is always up at www.conerlyconsulting.com/charts.php.

When Mortgage Rates Rise, Will Home Prices Fall?

I recently wrote about the mortgage lock-in effect that we will feel when mortgage rates increase. (I don’t expect that immediately, but over the next two or three years we could see rates rise a couple of percentage points.)

Some commenters suggested that home prices would fall after mortgage interest rates rose, adding further difficulties to those who might otherwise want to sell their homes and move.

Home prices, however, are not likely to fall after interest rates rise. There’s logic for thinking so, but it’s incomplete logic. Here’s why home prices might be thought to fall. A house is a long-lived asset. The value of any such asset (real estate, stock share, or bond) is the sum of the future stream of cash flow or benefits, discounted by the interest rate. With higher interest rates, the discounting reduces the present value of those future income (or psychic benefit) streams.

A simpler way to think of it is that at higher interest rates, fewer people can qualify for mortgages to buy a home; even if they qualify, they may not want to make higher payments. (This sounds different, but it’s merely a simplification of my first explanation.)

How can this logic be wrong? Let’s start with history. The chart does not show too much of an inverse correlation, except maybe for the early 1980s. Here’s a table of changes. I took every case from 1976 through the present in which mortgage rates rose by one percentage point or more. I then looked at the FHFA’s Home Price Index for that period. It turns out that in every case, home prices rose over the period in which mortgage interest rates are rising.

The one time in which home prices were falling was a time when mortgage rates were also falling. So what’s wrong with the theory described above?

Interest rates on mortgages, bonds, and other long-term debt are not set by the whims of fairies. They are determined by two factors: inflation expectations and economic growth, which combine to set the supply and demand for credit. Mortgage rates only rise when people feel good about buying houses: inflation is pushing up home prices, and more people have jobs. The higher demand for housing pushes home prices up despite the higher mortgage rates.

Will it work the same way the next time around? The world is increasingly global. It’s possible that global demand for credit would be strong even though one country’s economy is soft. If we are an island of weak economics in a sea of economic strength, then we could see home prices go down with higher mortgage rates. However, it’s even more likely that global economic strength would lead to domestic economic strength, pushing home prices up.

Of all the things to worry about, don’t worry about rising mortgage rates pushing down home values.

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Comments

When mortgage rates are at 10%, how the heck can people afford higher home prices when wages are declining. Housing is still in a bubble in most metro areas. Higher rates will collapse the housing market back to pre 2000 levels.

James, for most of the period from 1979 through 1990, mortgage rates were above 10 percent and home prices were rising. The appreciation over this period averaged 4.8 percent per year. The key is to understand what factors would lead to such high mortgage rates; those factors were also good for home values.

I totally agree with you. Considering “Median household income after inflation fell to $50,054, a level that was 8 percent lower than in 2007, the year before the recession took hold. ” I don’t believe we’ll be seeing higher home prices when rates start going up. Maybe if wall street and foreign money launderers keep outbidding each other for the rental market. But.. how much rent can one afford making 50K?

Betty, I suggest caution about interpreting the entire house demand based on median income. There are some technical problems with that measure, but the bigger issue is that a single measure misses the great diversity within households. Some people are struggling, but others are not. About one-third of households are renters, and most of them are in the bottom one-third of the income distribution (some permanently, others because they are young and just starting out). So for analysis of housing demand, we’re looking at the upper two-thirds. They are improving their financial conditions.

Let me add that I’m not a real optimist on housing prices–never have been. But I think the pendulum has swung too far to the pessimistic side.

I am not saying that prices will never go down. I’m saying if (when) they go down, it will be at the same time that interest rates decline, with common causality from weak economy. Or that strengthening economy will cause both interest rates and home prices to rise.

Are your figures adjusted for inflation? Or does that not matter since it would influence both the mortgage rates and home rates relatively equally? It seems as though inflation could skew the trends because it also changes y/y.

Brandon, good question. All the figures are nominal (not adjusted for inflation). In a high inflation environment, both interest rates and home prices typically increase. Interest rates rise because savers and investors demand compensation for their loss of purchasing power, while borrowers understand that they will be repaying their debts with bucks of lower purchasing power. Home prices rise in an inflationary environment as buyers see houses as an inflation hedge.

The difference between these historical data is that fundamentals drove those price increases, so that when subsequent interest rate hikes took effect, there was no commensurate decline in those prices. Now, the sole driver of the current price increases is the DECREASE in interest rates (every single data point on economics, such as wage, employment etc, is negative), so that when/if rate hikes take place now (and I predict they won’t for precisely this reason), it is much more likely that there will be a commensurate decline in prices.

Bill, I beg to differ with several of your comments though I hope that you are right. First, there are forces at play which do portend higher real estate prices are to come. The lack of inventory that is prevalent, not only in NYC but seemingly throughout the country. The fact that NYC experienced the largest influx of people into the city in over 50 years. The Fed’s pumping of cash into the system that has caused the asset price inflation of the last 5 years, stocks, bonds (read lower rates) and real estate. But…. your table of rate increases over the last 38 years showing gains while rates rose is a classic example of how statistics can be misleading. The fact is that despite these rises in rates, the real trend over the almost the entire period has been one of dramatically falling rates. From almost 18% to 3% and change in fact. Think of measuring incoming waves at the beach while the tide is going out. If you look at each wave individually, the water is rushing toward the shore, but if you look at the water as an ocean, the water is clearly moving away from the shore and will continue to do so until the tide turns. When it does, water will be able to be measured as moving away from the shore in between each wave, but the tide will carry anything swimming or floating in the water toward the shore. You then state that “Mortgage rates only rise when people feel good about buying houses: inflation is pushing up home prices, and more people have jobs.”. I have to differ here too. Mortgage rates are not set by people emotions. Mortgage rates are set by the bond market as money will go where it is treated best. If rates on treasuries rise rise then mortgage rates will rise, and no amount of borrower despair will keep them down (case in point, the run up to the peak in rates in the early eighties). So mortgages are the tail and Treasuries are the dog that wags them. Now what could make Treasuries rise in yield? I’m not talking about a rise spurred on by economic growth, that would be great, and is a possibility. But we have to look at the fact that rates are cyclical and the cycle is very likely near an end. When othe final low is in and I’m not positive it is, it is likely that rates will rise for 10-15 years, not in a straight line, but relentlessly like the tide. So let’s say China decides they don’t like us anymore and unloads much of the gazillions of $ worth of our bonds they own, rates will go higher and in a hurry…. Bad things in the financial markets tend to happen with more speed than good things, fear is a stronger emotion than greed. Stocks rise slowly but fall in crashes, rates grind lower but tend to spike higher….. I hope I’m wrong but I could see rates return to the 2008 levels….At that point the same payment that supports a $1,000,000 mortgage will only support a $541,000 mortgage, a pretty significant decline. Now maybe incomes will rise enough to offset wherever the rate rise takes us, but that would require a pretty big jump in income don’t you think? I go into it in a little more detail in this blog post… http://overnewyork.blogspot.com/2013/05/would-you-have-wished-you-sold-i-used.html and again, I’m not playing Chicken Little saying the sky is falling, there are some really good things out there too. just saying that this needs to be watched.